72246943 International Business Management QB

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Building a New International Financial Framework Agustn Carstens, Gobernador del Banco de Mxico

Aspen Insti tute Espaa, 30 mayo 2011


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Introduction

I would like to focus my remarks on three particular aspects of the

international financial framework that is being built:

The importance of strengthening current international coordination

efforts to pick up the pace on the global reform agenda, wider its

legitimacy, and prevent regulatory arbitrages.

The potential impacts of some of these measures on the banking

industry, and

The unintended consequences of some of the regulatory measures on

EMEs.


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The crisis and the regulatory agenda

We are witnesses to the most severe and extensive international financialcrisis since the Second World War. However, this time around theauthorities response has been swift and comprehensive.

A very ambitious regulatory agenda was designed and pushed forwardwith unprecedented international collaboration between developedcountries and EMEs. Several international bodies have been activelyinvolved, working under the aegis of the G20, and with the FSB playing animportant coordinating role.

[An acknowledgement should go to Mario Draghi as head of the FSB, who was recentlynominated to take over the leadership of the European Central Bank. His leadership

played a very important role in starting this process.]

The centerpiece of the agenda is the strengthening of capital and liquidity

standards, but it also covers many other issues such as standardizationand regulation of derivatives, the improvement of resolution processes,and the implementation of a macro-prudential approach to regulation andsupervision, including changes in institutional arrangements.


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Reshaping the international financial landscape

Both the crisis and the international reform agenda will leave a

profound footmark in the international financial landscape.

First, banks might try to seek greater diversification for their revenue

streams in the form of greater geographic reach and more stable

revenue streams, such as retail banking and payment services.

Second, the increase in the quality and quantity of capital will certainly

diminish banks profitability and induce banks to reduce their capital-

intensive activities, like structured finance and securitization

operations.

Third, the reform agenda incorporates a capital surcharge for banks

considered to be systemically important. One of the main criticisms of

this measure is that it may promote morally hazardous behavior.


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Unintended consequences of the reforms: impacts in EMEs

Since the crisis originated in the developed economies, most proposals areintended to address weaknesses identified in mature markets.

However, some of the proposed reforms could have important unintendedconsequences for some emerging market economies (EMEs ) despite thefact that EMEs were very successful in weathering the crisis.

Loss of liquidity in their debt and OTC derivative markets. Basel IIIincorporates important additional capital charges for some trading bookrisks. A likely result from this reform, as well as from the Dodd-Frank Actwill be a move away from proprietary trading or casino-like activities.

However, an unintended consequence of this measure could be areduction in liquidity in EME domestic financial markets. In many EMEs,banks are the main financial intermediary. Banks trading activities are a

very important source of liquidity for EME domestic sovereign debt andderivative markets. If banks become less willing to take positions in thosemarkets as a result of the higher capital charges, liquidity in EMEs marketsmight suffer and price volatility increase.


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Recalibration of sovereign risks. The international crisis isdeveloping quickly into an international debt crisis, particularly forsome countries in Europe.

This would lead to a recalibration of sovereign risks on the balancesheets of banking institutions. Banks will prefer to hold domesticsovereign debt (perceived as a risk-free asset) instead of foreignsovereign debt.

This poses a particular dilemma to global banks since they treattheir foreign subsidiaries holdings of domestic debt as if they wereforeign debt. The re-pricing of sovereign risks (the preference for domestic debt) and

higher capital charges for trading activities will create incentives for globalbanks to disinvest their subsidiaries from their debt holdings.

But Basel IIIs new liquidity regulations will force their overseas subsidiariesto increase their holdings of host-country sovereign debt.

The effect will be: an increase in the costs for investing in overseasretail banking activities and an increase in sovereign debt costs forhost countries with a large foreign bank presence.


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Unequal distribution of costs and benefits between home and host.

Capital surcharges for global banks could give rise to an asymmetricdistribution of costs and benefits between home and hosts jurisdictions.

Global banks are comprised of a constellation of branches and subsidiaries

which consolidate their balance sheets at the parent bank or holding

company level. Hence, if the capital surcharge is applied at a consolidatedlevel, the costs of holding more capital would be borne by all entities

belonging to the global group. However, their benefits will serve to protect

home-country stakeholders as parent banks are not subject to any legal

obligation to shield their overseas subsidiaries.

To avoid such an asymmetric treatment, a policy for capital surcharges

should establish that the surcharges be held by each of the legal entities

conforming a financial group in the same proportion in which each of

them contributes to the consolidated risk.


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Asymmetric sharing of information. Supervisory colleges and crisis

management groups have been set up for each of the major global banks. Since the crisis originated in the most important developed economies,

which are also home to most global banks, these supervisory mechanisms

were designed to address the concerns of home supervisors. Hence, they

are organized and coordinated by each home supervisor, which decides on

the membership.

Some host authorities have not been invited to participate in colleges of

global banks that may be systemic in their own jurisdictions but are less

relevant from the home-country perspective.

In the same vein, home supervisors have agreed to share among

themselves all information pertaining to global banks. However, they arevery reluctant to give host authorities access to relevant information.

We need to revise the criteria for membership on supervisory colleges and

revise the agreements on information sharing.


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Concluding remarks

The global regulatory agenda will reshape the international financial

system, making the world a safer place by inducing bankinginstitutions to become a more diversified and self-insured business.

Nevertheless, it is of paramount importance for the international

community to review its priorities and regain the consensus that

characterized the reform agenda at its outset.

For the reforms to succeed, it is imperative that the international

setting bodies are no longer perceived to address the concerns of

the most developed nations. They need to recover their legitimacy.

The reform agenda should take into consideration some facts

regarding the regulation and supervision of global banks: Supervision plays a key role in preventing financial crisis. National

supervisory processes should be internationally assessed.


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Concluding remarks

The leading role of home supervisors should be revised. Global banks

operate as single economic units, but they are comprised of entitiessubject to different legal jurisdictions. Host countries cannot rely on

home supervisors when protecting their citizens and financial systems.

Each domestic financial authority is ultimately responsible for its

banks and depositors and accountable to taxpayers.

Global banks could be a source of strength but also of contagion. It is

key to stress the importance of having in place business models that

limit contagion among the different components of a global bank and

facilitate the spin-off of subsidiaries and business lines in a resolution

process. Resolution processes are essentially territorial (they do not

have cross-border reach). The Spanish model of stand-alone

subsidiaries operating at arms length is a good example of this.


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72246943 International Business Management QB